CALM Longs Walking on Eggshells

At the most recent meeting of the Boston College Investment Club, we
had three stock pitches – a sell pitch for Wachovia (NASDAQ:WB), a buy pitch
for Astra-Zeneca (NYSE:AZN), and a buy pitch for Cal-Maine (CALM. Because Cal-Maine is by far the most underfollowed of
these, I found it most interesting that someone would find (and then
present) this idea. While the numbers on Cal-Maine make it look
attractive, I believe there are a number of red flags that make me
exceptionally wary to agreeing to a purchase.

Cal-Maine is the
largest domestic producer of eggs, as well as the only publicly traded
egg producing company. After a huge run-up of late, the company has a
market valuation of just over $700 million. Cal-Maine had a huge first
quarter this year, and turned more in profit than it did all of last
year combined. This gives the stock a very low P/E (about 5x and
change), and profitability ratios (i.e. return on equity) that look
extremely attractive. Betting on CALM here is betting that things
really are different this time, because the absolute worst time to buy
a cyclical stock is when the earnings multiples are lowest. Maybe we
are in the middle of a great supply/demand situation for egg farmers
that will hold into the future, Cal-Maine will continue to be highly
profitable, the stock runs 20 points and I look stupid. Maybe, however,
this is a case of the longs in a stock getting confused about why
things look so good (see: the
tech darlings of 2007) – because Cal-Maine is not part of the
secular agriculture boom. If anything, they’re hurt through it via
higher feed prices, and I’m feed prices will stay high as long as our
government continues the subsidizing of corn, wheat, soybeans, etc.,
through the burn your food, fuel your car program known as ethanol – a
program so insanely contrived, it is literally responsible for death
and political unrest all around the world. But I
digress…

I believe the presentation unfairly
glossed over this fact, as there was a lack of adjustment for seasonal
factors, leaving the implied annual earnings and dividend yield far too
high. It’s the equivalent of pretending every quarter for a retailer is
like the last six weeks of the calendar year… ok, perhaps a bad analogy
in light of how terrible retail sales have been, but hopefully you
catch my point. But to make it concrete: gross margins in Q1 2008 were
37%; in Q2 2007 gross margins were 24% - obviously making for some wild
intra-year swings.

Another point made by the two
presenters was that CALM has a very low correlation to the BCIC
portfolio as a whole, so while it might be a risky or volatile stock in
itself, adding it to our portfolio will add diversification benefits.
Specifically, it was pointed out that our exposure to consumer
nondurables was low after our sale of Village Supermarkets (NASDAQ:VLGEA) – a sell pitch that I was responsible for. This would be a chance to essentially practice “moat
arbitrage” and eschew a company like Cal-Maine that has a
very narrow moat at best in favor of an established food producer that
can command a premium for its products – examples include Campbell Soup
(NYSE:CPB), General Mills (NYSE:GIS), Kellogg (NYSE:K), and Kraft (KFT). While none of
those companies offer the hypothetical upside a Cal-Maine does in a
scenario where, say, egg prices soar to new highs, they also won’t get
crushed like Cal-Maine will when this commodity business rolls over the
cycle.

There, I said it. Cal-Maine is a commodity
business – albeit the biggest player in it, which offers some scale
advantages, but not enough to make it anything special. More
problematic, supply in the egg industry is constrained only by how many
chickens can be hatched and how many cages can be built. While the
latter point has worked in favor of the egg industry of late, it is
assured that more capacity can be brought online – unlike in a hard
asset commodity business like oil, copper, etc., where there is a
finite amount of the stuff in the ground… but I digress. Sticking to
agricultural commodities, I think eggs are even less favorable than
grains, because land used for grain planting has been in decline for a
prolonged period of time, and there is a relatively low ceiling on the
amount of production that can be taken from any planting area in a
finite time. Eggs, on the other hand, can be produced by stacking
dozens of cages on top of each other and having each chicken produce a
couple hundred eggs per year. What does the evidence point to in terms
of industry supply trends? Yes, supply has been constrained – but it
looks to be gradually expanding, as pullet chicks hatched is at a
multi-year high, as is eggs under incubation – in other words, farmers
are breeding more chickens to capitalize on the high prices. As
invariably happens in a commodity business, this will cannibalize
margins and profits.

Along the lines of cannibalizing
profits, while Cal-Maine will realize cyclical prices for its eggs
(again, egg prices have fallen 25% since Easter and will fall further),
they are going to be hit by much, much higher prices for feed –
somewhere in the neighborhood of 50% higher than the same time last
year is possible, judging from industry data. And this is where I
believe people have it wrong about this stock: Cal-Maine has traded
like it is part of the secular agriculture boom, when its main source
of revenues is probably a 1-2% growth business. On the flip side, its
cost inputs will be affected by the secular move up in the inputs that
go into feed – namely corn and soybeans. This is why I’m
betting…

Shorts have been all over this stock. CALM
has an enormous short position that has continually been ratcheted up
even as the stock rose. More than 75% of the float is short. Now read
that again. We all know what a short squeeze is, and so do the hedge
funds that are behind this short position. When the shorts are willing
to place this large of a bet against a stock, that alone should tell
you something. But when that underlying stock is an extremely cyclical
business with profits at a high and a stock price that follows… I have
to believe that the shorts are right here, and Cal-Maine’s
profitability (and stock) is going to get hit.

The
Powerpoint on for the CALM buy pitch is uploaded for viewing on my site.

We only use your contact details to reply to your request for more information.We do not sell the personal contact data you submit to anyone else.

Thank you for your interest in Seeking Alpha PROWe look forward to contacting you shortly for a conversation.

Thank you for your interest in Seeking Alpha PRO

Our PRO subscription service was created for fund managers, and the cost of the product is
prohibitive for most individual investors.
If you are an investment professional with over $1M AUM and received this message
in error, click here and you will be contacted shortly.

Thank you for your interest in Seeking Alpha PROWe look forward to contacting you when we have an individual investor product ready!